Credit strategists at Barclays say the S&P 500 Index is currently “at a peak relative to credit spreads, with the implication that equity markets see upside that is not priced into credit.”
Barclays says equities have declined since early May but remain expensive compared with levels seen when European sovereigns and commodities last reached their extremes. Meanwhile, valuations have increased in the past several weeks as equity prices have fluctuated within a range but earnings estimates for 2012 have continued to decline.
Barclays says equity volatility is near its lows relative to credit spreads, and while VIX remains low compared with credit, it has increased in recent weeks, suggesting that stress in the market has ticked up. “On balance, we interpret the extremes in these relationships as indicating significant risks to global growth and the potential for downside from Europe, balanced by the potential for upside if the U.S. economy improves or if European concerns are averted.”
Relative to other risk assets, Barclays says investment grade credit “is at an uncomfortable balance point” with spreads “at an unstable level,” saying they should be either significantly tighter or significantly wider, with the fact that they’re trading in the middle the past year’s trading range “reflect[ing] a lack of direction in the market,” Barclays writes. “The relationship between credit and equity volatility suggests credit tightening, but commodities and European peripheral spreads suggest widening.”
On the high-yield front, Barclays says it’s less negative on the high yield market now that it is trading with average yields closer to 8% and average prices below par. While the lowest-rated CCC-rated bonds remain the top performer for the year, Barclays says growth forecasts are moving closer to a level at which CCCs begin to underperform, saying CCC returns tend to break down below 1.5% GDP growth.
Barclays says high-yield spreads have been attractive for some time relative to default rates, but correlation is even higher with the VIX and liquidity. “With volatility higher and bid-ask wider in recent years, the current elevated amount of non-default loss compensation appears justified,” Barclays writes. “In practice, while spread is closely tied to default rates, it reacts more quickly to changes in volatility and liquidity. With both of these metrics expected to remain elevated and Treasuries at record lows, we believe spreads can stay disconnected from default rates for an extended period.”
Barclays also points out that the rapid reversal of fund flows recently caused a significant increase in price volatility, particularly for ETF benchmark constituent bonds, creating dislocations within industries and sometimes even within individual capital structures.